What might US pension funds reply to Britain’s Trades Union Congress (TUC) about the dangers of private equity? Ahead of June’s G8 summit, the TUC’s general secretary, Brendan Barber, is going to ask pension funds from other countries to rethink their investment policy and stop fuelling buyout fever. Barber said private equity firms “sometimes give the impression of being little more than amoral asset-strippers after a quick buck”.
This year US pension funds are likely to increase their commitments in private equity worldwide thanks to a little-noticed new provision in the Pension Protection Act (PPA) of 2006. The trend is worrying some critics of state pension funds, which in the US are the biggest single source of capital for private equity firms. They provided 22% of all new money raised in 2005, according to the latest available data.
In the same year their funding level ratio - actuarial value of assets divided by the actuarial accrued liabilities - deteriorated to a mean of 81.8% compared with 83.5% in 2004, according to a Standard & Poor’s survey.
This is the opposite of what is happening in the private sector. With poor financial health, state pension funds are tempted to invest in riskier assets in search of higher returns, but they may arrive at the highest point of a bubble, like at the end of the 1990s.
A case in point is the $26bn (€19.7bn) South Carolina State pension fund. It was once ultra conservative, only investing in bonds until a constitutional amendment introduced domestic stocks in 1999, just at the peak of the equity bubble. Its 2005 funding ratio is 80.3%, below the national average and down from almost 100% in 1999. Last November another constitutional amendment allowed alternative investments for the first time, with a target of investing 15% in hedge funds, real estate and private equity. Is the bust arriving?
Contributing to the private equity boom are the new definitions of ‘benefit plan investors’ set by the PPA. In order to admit US investors, private equity fund managers must establish whether any of them are subject to the US Employee Retirement Income Security Act of 1974 (ERISA). If any US investor is subject to ERISA, the fund manager must ensure that either less than 25% of the fund is held by ‘benefit plan investors’ - the ‘25% test’ - to avoid onerous fiduciary obligations, or the fund qualifies as a venture capital operating company, which is burdensome.
The PPA makes it easier to satisfy the 25% test, because the new definition of ‘benefit plan investors’ excludes government plans and non-US plans that used to be included. Besides, when applying the test, funds of funds with some ERISA assets will generally count for less under the new Act than under the old rules. The bottom line is that it will be easier for many private equity funds to accept US pension funds money.
One last factor favouring the growth of private equity in the US is politics, with private equity managers shrewd enough to represent themselves as politically correct. In the recent $32bn buyout of Texas utility TXU Corp, for example, Texas Pacific Group and Kohlberg, Kravis, Roberts, two of the biggest US private equity firms, successfully depicted the deal as ‘green’, with claims it will reduce global warming as TXU will build fewer coal plants than previously planned.
The idea pleases the numerous state pension funds that invest with TPG and KKR, and that have been pressuring other firms to be eco-friendly, no matter what British unions say.
‘Time to cash in on surplus’
he sky looks cloudy for US defined benefit (DB) pension plans which have to deal with new accounting rule, FAS 158. At end-2006, for the first time since 2000, the 79 DB schemes offered by Fortune 100 companies held an aggregate surplus of $23bn (€17.4bn), according to an estimate by benefits consultancy Towers Perrin. Their funding level, assets to liabilities, was 102.4%, up from the 91.6% at the end of 2005 and from the low point of 81.9% in 2002, although still below the 125.8% recorded in 1999.
The average portfolio return was 12% in 2006, above the expected 8.1% disclosed in financial statements. At the same time, the discount rate used to measure liabilities increased by about 25 bps, reducing liabilities by 3%. In addition, firms have increased contributions more than five-fold since 1999. But under FAS 158, Fortune 100 companies will also need to recognise any deferred pension costs, including medical and life assurance expenses, for a total $242bn at the end of 2006, according to Towers Perrin. This is why they should take the opportunity of surplus “to reduce the financial risk associated with their plans by cashing out benefits, buying annuities or hedging against interest rate and equity risks”, says Towers’s managing director Steven Kerstein.
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